For most people, reaching retirement will be the biggest financial event of their lives. It is a big jump from receiving a regular salary and the benefits that come along with that, to living off what you have saved.
The risks of getting this wrong are severe. Making a mistake at this point could jeopardise all the years of hard work that have led up to it.
Speaking at the Alexander Forbes Planning for Retirement seminar in Stellenbosch, financial planner Estian Visagie said that there are essentially six important decisions that need to be made at retirement, and they are all inter-related.
How much of my capital do I withdraw as a lump sum?
Current pension fund law in South Africa allows you to withdraw up to one third of your pension fund at retirement as a lump sum. The first R500 000 of this is tax free, with rates increasing as the amount goes up.
Even though they may be able to take more, many people only take R500 000 as they don’t want to pay tax on anything above that. However, as Visagie pointed out, this may not be the most efficient option in the long term.
“There may be a good reason for withdrawing more,” he said. “If the income tax you are going to pay over the long term is more than you would pay once off, this might make sense.”
It’s important to bear in mind that whatever you don’t take as a lump sum has to be used to buy an annuity, and any money paid out of that annuity will be taxed as income. Money taken as a lump sum can however be invested in a unit trust portfolio, where future withdrawals should be seen as capital gains and therefore taxed at a lower rate.
Which products do I need?
At least two thirds of your retirement capital has to be used to buy an annuity (discussed below), but you also need to consider the rest of your money. Where will you invest emergency funds, for example, or can you afford to give up some liquidity in order to use products that offer some sort of capital guarantee?
You also need to consider how to structure your portfolio so that it is efficient in terms of taxes and estate duties over the long term.
What should my asset allocation be?
Retirement is not a single event. You will go through different stages, and your needs will be very different as an active 65-year old to what they will be as a frail 95-year old. You need to consider how you will cater for these different times.
It is therefore important to look across your entire portfolio to understand your asset allocation, whether it’s suitable, and how it needs to change over time. This would also include considering physical assets like property.
“You can’t just look at the investments,” Visagie said. “You have to look at your total wealth position.”
What kind of annuity should I choose?
There are essentially two types of annuities one can choose at retirement: a living annuity, which is linked to an investment portfolio; or a guaranteed annuity, which is underwritten by an insurance company.
Living annuities have become very popular as you keep control of your capital and when you die it forms part of your estate. However, your income could be at risk if the investments perform poorly, and you take the risk of outliving your money.
Guaranteed annuities secure you an income for life, but once you’ve purchased a pension, you can’t undo that decision.
If you choose a living annuity, however, you could at a later stage take that money and buy a guaranteed annuity. Some, but not all providers, even allow you to use a portion of your capital to buy a guaranteed annuity, which can become a very useful option as you get older and insurers offer more favourable rates.
How much can I withdraw from my capital?
This is most relevant to anyone using a living annuity, but even if you purchase a guaranteed annuity, you may still have discretionary savings. How much can you afford to withdraw from this every year?
“A lot of people use the 4% rule, but the reality is that if the markets dip, that 4% could suddenly become 5%,” Visagie pointed out. “Do you adjust your income lower if that happens?”
Nobody is ever likely to reduce their income. So what’s important is to have a long-term plan in place that will be sustainable despite market fluctuations.
How do I align my investments with how much I need to withdraw?
In basic terms, if you want to withdraw 10% a year as income, your capital needs to grow by 10% (after fees) to allow for that to be sustainable. If you then want an inflation-linked increase on top of that, you would have to add the inflation rate to that as well. In the current environment, that would mean you need to grow your capital at an annual rate of 16%.
There is no investment that can deliver that kind of return sustainably over the long term. And as Visagie pointed out: “You can’t create cash out of thin air”.
You have to therefore balance your needs against what you can realistically generate from your portfolio without taking any undue investment risk, or putting yourself at risk of inflation destroying your purchasing power.
“Your investment strategy after retirement differs vastly from what you do before retirement,” Visagie said. “And if you make a mistake there, you compromise your retirement significantly.”
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